OTC clearing VI: Will OTC clearing increase systemic risk?

In the final part of our series on OTC clearing, William Mitting looks at the biggest question of all: is the OTC clearing mandate increasing systemic risk?

The ultimate intention of the mandate to centrally clear
standardised OTC derivatives was intended in part to reduce
systemic risk in the financial system. However, could an
unintended consequence be that it actually increases the
problem of too big to fail and increases systemic risk?

In a report for the Cato Institute entitled "The
Inefficiency of Clearing Mandates" Craig Pirrong says that OTC
clearing has become "a deus ex machine" to solve all the
problems inherent in the derivatives markets.

He added: "Those making such claims would be at risk of a
false-advertising claim if they were engaged in commercial
advertising."

Pirrong argues that the central clearing mandate could
increase moral hazard, relating it to a tragedy of the commons:
"Each dealer has an incentive to trade too much because it does
not bear the associated default costs...and each has an
excessive incentive to add risk to its balance sheet because
other members of the clearinghouse bear some of these risks,"
he says.

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